Wednesday, August 6, 2008

AIG's Dismal Results: Trouble For Pension Funds?

American International Group Inc. (AIG), the world's largest insurer reported a massive second quarter loss after the market closed today. The insurance giant said it lost $5.36 billion in the second quarter or $2.06 a share, compared with a profit of $4.28 billion or $1.64 in the same period a year earlier, sending shares down 7.7 percent in after-hours trading.

Excluding one-time charges for write-downs and impairments, AIG lost 51 cents a share. The result is worse than the profit of 63 cents a share that analysts were expecting, according to a poll by FactSet Research.

The company took a realized capital loss of $6.08 billion on its investment portfolio in the second quarter. AIG also took a $5.56 billion write-down on the value of its senior credit default swaps. Basically, credit default swaps are insurance on bonds to protect the bondholders from default.

"Our second quarter results were adversely affected by the severe conditions in the housing and credit markets and a very difficult investment environment," AIG's new CEO Robert Willumstad said, according to MarketWatch. "We have a lot of work to do to restore AIG's profitability to where it should be."

These dismal results put to rest the myth that the credit crisis is over. In fact, things are getting worse. These results also give us a glimpse of what we can expect from large public pension funds when they report their results next year.

To understand why, you need read a Bloomberg article posted earlier today prior to the release of earnings which highlights the issues plaguing AIG:

The insurer may post as much as $7 billion of second- quarter writedowns for credit-default swaps on top of about $20 billion in losses from previous quarters, Wachovia Corp. analyst John Hall said in a July 15 research note.

"We don't see near-term relief in sight'' for AIG's swaps, as securities linked to the derivatives lost value, Hall said. He cut AIG to "market perform'' from "outperform'' last month.

There are "key question marks'' concerning AIG's risk controls, Societe Generale SA analyst Emmanuelle Cales said in a research note dated today. The firm started coverage of AIG with a "sell'' rating.

"We do not see how AIG could quickly reduce its large exposure to the subprime market,'' Cales said.

AIG raised $20.3 billion in May by selling debt and equity to replenish capital and protect against further writedowns. Citigroup Inc. analystJoshua Shanker said in a research note that month that AIG may seek $10 billion more.

Catastrophe costs and slipping returns from hedge funds may also weigh on AIG's results. Natural disasters in the U.S., including a record number of tornadoes, cost insurers about $6.03 billion in the second quarter, the most since 2001, according to Insurance Services Office Inc. Allstate Corp., the largest publicly traded U.S. home and auto insurer, said second-quarter profit plunged 98 percent to $25 million on storm costs and investment losses.

Earnings from private equity and hedge fund holdings were probably close to zero in the second quarter after returns fell 84 percent to $197 million in the period ended March 31, Shanker said. AIG had $29.4 billion of so-called "alternative'' holdings as of March 31.

If Shanker’s report proves to be true, that will make it two dismal quarters in a row for AIG’s earnings on its alternative assets investments. AIG’s first quarter profits declined 84% in the two asset classes due to a tightening credit market. Although the insurer did turn in a profit of $197 million from its investments, that paled in comparison to the $1.22 billion profits from the first quarter in 2007.

The company, based on figures disclosed in June, had nearly $30 billion invested in hedge funds and private equity firms.

But returns have been in a slump in the months since the credit crisis set in. Industry tracker Hedge Fund Research's multi-strategy index posted losses of 2.5 percent in the first half of the year, while a fund of funds composite index was down by 2.3 percent. Citigroup's Shanker said AIG, which earned $700 million from these investments last year, is unlikely to see any income from hedge funds or private equity in the second quarter. "We believe that such a disappointment could prove concerning to investors."

That last paragraph is worth noting given that many large public pension funds in Canada and elsewhere allocate substantial weightings to alternative investments which include hedge funds, private equity, real estate, infrastructure, commodities and timberland.

Declining returns in alternative investments which are supposed to act as buffers when traditional stocks and bonds decline is all part of the great deleveraging process that I alluded to in an earlier comment. As risk appetites shrink, so will the returns on this monster alternatives that were significantly levered to generate higher returns. The "alternatives" party is over and investors better revisit their redemption policies and strategy weights, focusing on risk management and limiting their losses.

Note: If you read the Reuters article above, you will see that some investors, including Fidelity Investments' flagship Magellan stock fund, Fifth Third Asset Management and Bill Gates' charitable foundation, have been buying AIG shares. According to the MFFAIS website, most institutions and mutual funds are selling AIG.

A quick look at this chart tells me to buy in the low 20's for a quick tradeif a double bottom holds. But unless we get a clear uptrend above the 50 and 200 day EMA, I do not see any reason to hold AIG shares in your portfolio at this time. Institutions should remain underweight financials and insurance companies until we get clear signs that the housing market has bottomed. (No, it has not bottomed yet!!!)

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